Eroding Market Stability by Proliferation of Financial Instruments

26 Pages Posted: 23 Nov 2008 Last revised: 25 Nov 2009

Fabio Caccioli

International School of Advanced Studies (SISSA)

Pierpaolo Vivo

Abdus Salam International Centre for Theoretical Physics (ICTP)

Matteo Marsili

Abdus Salam International Centre for Theoretical Physics (ICTP)

Date Written: November 21, 2008

Abstract

We contrast Arbitrage Pricing Theory (APT), the theoretical basis for the development of financial instruments, with a dynamical picture of an interacting market, in a simple setting. The proliferation of financial instruments apparently provides more means for risk diversification, making the market more efficient and complete. In the simple market of interacting traders discussed here, the proliferation of financial instruments erodes systemic stability and it drives the market to a critical state characterized by large susceptibility, strong fluctuations and enhanced correlations among risks. This suggests that the hypothesis of APT may not be compatible with a stable market dynamics. In this perspective, market stability acquires the properties of a common good, which suggests that appropriate measures should be introduced in derivative markets, to preserve stability.

JEL Classification: G10, G12, D43

Suggested Citation

Caccioli, Fabio and Vivo, Pierpaolo and Marsili, Matteo, Eroding Market Stability by Proliferation of Financial Instruments (November 21, 2008). Available at SSRN: https://ssrn.com/abstract=1305174 or http://dx.doi.org/10.2139/ssrn.1305174

Fabio Caccioli

International School of Advanced Studies (SISSA) ( email )

via Beirut 2-4
Trieste, 34014
Italy

Pierpaolo Vivo

Abdus Salam International Centre for Theoretical Physics (ICTP) ( email )

Strada Costiera 11
34100 Trieste
United States

Matteo Marsili (Contact Author)

Abdus Salam International Centre for Theoretical Physics (ICTP) ( email )

Strada Costiera 11
Trieste, 34014
Italy

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